Earlier this week, I tried to take on the thorny issue of whether equities are cheap or not.
The answer? Depends what you call cheap. There aren’t many indicators with a good history of telling us when we should and shouldn’t buy the market. One that does is the cyclically adjusted p/e ratio (CAPE). Look at that today and equities are definitely not cheap. Indeed, as CSLA’s Russell Napier points out, “despite a decade of dire returns”, CAPE, while well below the nonsensical peaks of the late 1990s, is still not far below the “dangerous peaks seen in 1901 and 1966” (around 24 times).
The 30% drop in the S&P 500 since 2000 has made equities less expensive, but not cheap. Napier concludes, much as I did, that “long-term investors should not consider investing in equities”. At some point there will be a final lurch down, one that will bring CAPE back to cheap levels and make the water safe for the long-term investors most of us claim to be. But what is true for the long-term investor is not always true for the short-term investor.
Think back to 1995: then, CAPE was also at 1966 levels. But anyone who had sold out then would have felt pretty foolish by 1999. The same happened in 2003, when again CAPE was still high at 21 times. By 2007 the index had doubled. Anyone who refused to buy, or who sold in 1995 or 2003, would have been entirely vindicated – by 2009 share prices were back to 1995 levels. But they’d also have made a lot of money if they’d ignored CAPE and poured money into stocks for a couple of years. So the real question now is not are equities cheap (they are not), but are there any forces out there that might allow them to get even more expensive before the ‘gravity of value’ precipitates their final collapse?
Napier’s answer is yes. There are various valuation methods he thinks suggest short-term cheapness. But his key point is that markets are, to a degree, pricing in deflationary depression (and therefore a huge fall in corporate earnings and dividends). I fear this outcome less than I once did, but Napier doesn’t fear it at all. Instead, he points to “comprehensive and timely data” that show “US deleveraging is probably over”. He sees bank credit expanding, the commercial paper market showing some growth and a strong chance that “early-stage inflation” is on the way.
Napier’s conclusion? Buy equities now and you will be taking part in the “last major rally” of this long-term bear market. He may be right – times are hard to read. But if you want to risk it, be nimble about it – you don’t want to stay in too long. And hedge yourself by buying the cash-generative, dividend-raising multinationals we keep pushing. You might also look at my interview with Michael MacPhee. I didn’t come away much the wiser on deflation, but he did come up with some fine-sounding stock tips.